Andrew Karolyi is the faculty director
of the Emerging Markets Institute,
Alumni Professor in Asset Management,
and professor of finance at Johnson.
An internationally known scholar
in the area of investment management,
with a specialization in the study of international
financial markets, he has
published extensively in peer-reviewed
journals of finance and economics,
and his research is covered extensively
and regularly in the business press. He
also serves as editor of the Review of
Financial Studies, one of the top-tier
journals in finance, and is an associate
editor for a variety of journals. Karolyi received his BA in economics from McGill
University and earned his MBA and PhD in finance at the Graduate School of
Business of the University of Chicago. He is actively involved in consulting with
corporations, banks, investment firms, stock exchanges, and law firms. This fall,
he is serving as a visiting scholar in the research department of the International
Monetary Fund.

Vantage Point

The emerging market swoon of 2013:
Fed-inspired or just investors dog-tired?

By Andrew Karolyi

It has been another bumpy ride in most emerging markets this year.
Currencies and bourses from Sao Paolo to Mumbai and Budapest
to Johannesburg have been beaten down, rebounded, and then were
beaten down again. Volatility reigns supreme once again.

None of this is a surprise, of course. Emerging markets are
almost hard-wired to be vulnerable to dramatic inflows and outflows
of money that induce the kind of dislocation in market valuations
we have seen this year. This summer, Ben Bernanke and the U.S.
Federal Reserve have been the special object of scorn for emergingmarket
central bankers, market regulators, and fiscal policy
authors for having inspired the painful capital flow withdrawals
they have endured. In June, Mr. Bernanke and his Federal Open
Market Committee colleagues laid out a responsible timetable with
conditions for the withdrawal of monetary stimulus — the so-called
“tapering” exercise. He cautioned that the scale-back in the Fed’s
$85 billion per month bond-buying program would only happen if
economic data were better and added that interest-rate hikes were
still far into the future.

What was the reward for his effort at greater Fed guidance? In
the Group of 20 communiqué in September, a number of political
leaders expressed grave concerns about what they saw as the turmoil
unleashed by the prospect of the U.S. slowing the flood of dollars
into the world economy. The leaders of Brazil, China, Russia,
India, and South Africa specifically commanded “an eventual
normalization of monetary policies to be effectively and carefully
calibrated and clearly communicated.” These very countries
announced they would commit $100 billion to a currency reserve
pool that could help them jointly defend against balance of payment
crises. Read: insurance against further Fed policy shocks.

Lots of research has shown that global risks, like unexpected
shifts in monetary policy in the developed world, are important
factors driving waves of capital flows in emerging markets. As global
risks increase, investors either stop investing abroad and retrench
to their home-country markets, or they leave their home-country
markets and flee to markets with more stable financial systems.
One cannot help but wonder, however, if the Fed’s prospect for
tapering as a driver of the current swoon, while influential, may
be overstated. A more fruitful perspective would be to turn one’s
gaze inward rather than wave one’s fist outward. Perhaps emerging
market leaders need to focus less on trying to manage external
influences beyond their control and refocus their energies in favor
of resourcing the kinds of institutions that make it more attractive
for global investors as a long-term play. After all, it is these very
investors that help these countries solve the undercapitalization
problems that impede their long-term growth potential.

What are these institutions that can alleviate global investors’
concerns and thus dampen down excessive capital flow volatility?
Research shows that responsible long-term-oriented investors care
deeply about market transparency and sound corporate governance
standards. They want to reduce arbitrarily tough restrictions on
market access for foreign interests and especially the uncertainty
about how these restrictions apply and are enforced. Deeper capital
markets and more operational systems for the trading of securities
are critical toward heightening investor confidence. Global investors
care about strong legal protections for minority investors in public
corporations in the event of a dispute resolution with respect to
actions (or inactions) of family- or management-led controlling
stakeholders. Long-term investors also care deeply about a stable
political environment.

The good news is that there are lots of examples that emerging
market regulators and political leaders are making serious
investments in improving these institutions. Consider Brazil’s Novo
Mercado, a listing segment of the BM&F Bovespa for the trading
of shares issued by companies that commit themselves voluntarily
to adopt corporate governance practices above and beyond those
required by law. Since its founding over 10 years ago, mostly positive
outcomes have been seen in terms of value, liquidity, and capitalraising
capacity for the firms that have signed contracts to adhere to
a set of good corporate governance practices.

Another good investment is in stronger cooperation among
regulatory authorities in emerging and developed markets. This
year, the U.S. Public Company Accounting Oversight Board
(PCAOB) announced that it had entered into a memorandum
of understanding on enforcement cooperation with the China
Securities Regulatory Commission and China’s Ministry of Finance.
The goal of the agreement is to facilitate joint inspections in China
of audit firms that are registered with the PCAOB and that audit
Chinese companies that trade on U.S. exchanges. It is a solid step
toward protecting the interests of global investors who lean on U.S.
institutions, like the Securities and Exchange Commission and the
PCAOB, to ensure the integrity of financial statement disclosures
and to facilitate good governance practices of the many companies
from around the world that list and trade on those markets.

Global investors seek predictable and reliable market access in
emerging markets. Almost immediately following his late August
appointment, Reserve Bank of India’s Governor Raghuram Rajan
announced a series of reforms to liberalize the banking sector, to
strengthen capital market institutions, and to close some gaps in
securities market regulation. It came not a minute too soon, with the
rupee’s dramatic decline and an exit of almost $1 billion from equity
markets during the preceding month. Specific proposals included
the promotion of more small, private banks; disinvestment in small,
underperforming state-run banks; the freeing up of branch licensing
rules; and generally greater participation of foreign investors in
Indian capital markets.

These are very good developments, but the work is not yet
done. So much more can be done to secure the confidence of responsible, long-term global investors to emerging market stock,
bond, and currency markets. Investors want to see a bigger effort
toward increasing operational efficiencies of the trading markets,
toward limiting or even eliminating arbitrary restrictions on foreign
investor access that distort capital flows, toward toughening legal
protections for minority investors, and toward blocking potentially
predatory government actions that distort well-functioning market
mechanisms. Attracting such investors to their shores has to be the
best medicine to stabilize underlying flows and to secure financing
for the steady long-term growth they so desperately need.